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in inflation-adjusted, interest-bearing assets. We
observed this in Brazil and Argentina during periods of high inflation.

4. Are there any other reasons why engaging in an inflation tax is not good policy?

Answer: Inflation imposes many other costs on the economy besides the inflation tax:
shoeleather costs, menu costs, tax distortions, confusion, etc.

Chapter 31
Suppose you are having breakfast with your parents one Sunday. Your father is reading
the paper and comments on a report that the exchange rate for the pound has just hit its
lowest value in a decade. He reads on and then exclaims that JCB, a heavy equipment
manufacturer, has reported that sales of their earth moving equipment have hit an all time
high. Your parents are shocked by the report's positive view of the low value of the pound.
They’ve recently abandoned plans to visit Australia because of the pound’s low value.
1. Why might JCB and your parents have different opinions about the value of the dollar?
Answer: JCB sells much of its equipment to foreigners and the low value of the pound
makes JCB’s products cheaper to foreigners. Your parents were going to buy foreign
goods and services and the cost in pounds became higher.
2. JCB imports many parts and raw materials for their manufacturing processes and they
sell many finished products abroad. If they are happy about a low pound, what must be
true about the ratio of JCB’s imports and exports?
Answer: JCB must sell a greater value of products abroad than they purchase. That is, the
company is a net exporter.
3. If someone argues that a strong pound is "good for the UK" because UK residents are
able to exchange some of their GDP for a greater amount of foreign GDP, is it true that a
strong pound is good for every UK resident? Why?
Answer: No. A strong dollar benefits UK residents who are net importers and harms K
residents who are net exporters.
Chapter 32
Hong Kong has a capitalistic economic system. It was leased from China by Great Britain
for 100 years. In 1997, it was returned to China, a socialist republic.

1. What do you think this event might have done to the net capital outflow of Hong Kong?
Answer: It might have increased the NCO of Hong Kong because of capital flight.
Investors in Hong Kong, fearing that China may nationalize much of Hong Kong’s industry,
would buy assets abroad; and foreign investors would not wish to buy assets in Hong
2. If the residents of Hong Kong chose Canada as a place to move some of their business
activity, what impact do you suppose this will have on the value of the Canadian interest
rate and exchange rate? Why?

Answer: This will decrease Canada’s NCO. This shifts the demand for loanable funds left
and lowers the real interest rate. The reduced NCO reduces the supply of Canadian
dollars in the foreign-currency exchange market, raises the exchange rate, and moves NX
toward deficit.

3. Which Canadian industries, those engaged in importing or exporting, are likely to be
pleased with Hong Kong's investment in Canada? Why?

Answer: The increase in the value of the Canadian dollar will make Canadian producers
less competitive abroad, but will make imports cheaper.

4. What impact will Hong Kong's return to China have on the growth rate of Canada?

Answer: The reduction in Canada’s NCO (due to Hong Kong’s increased NCO) increases
the capital stock of Canada, causing it to grow.

Chapter 33
Suppose you are watching the evening news on television. The newsreader reports that
union wage demands are much higher this year because the workers anticipate an
increase in the rate of inflation. Your flatmate says, "Inflation is a self-fulfilling prophecy. If
workers think there are going to be higher prices, they demand higher wages. This
increases the cost of production and firms raise their prices. Expecting higher prices
simply causes higher prices."
1. Is this true in the short run? Explain.
Answer: Yes. An increase in price expectations shifts the short-run aggregate supply
curve to the left and prices rise.
2. If policymakers do nothing and allow the economy to adjust to the natural rate of output
on its own, does expecting higher prices cause higher prices in the long run? Explain.

Answer: No. In the long run, the increase in unemployment will cause wages and price
expectations to fall back to their prior levels.

3. If policymakers accommodate the adverse supply shock, does the expectation of higher
prices cause higher prices in the long run? Explain.

Answer: Yes. If policymakers accommodate the adverse supply shock with an increase in
aggregate demand, the price level will rise permanently.

Chapter 34
Suppose you are watching the news on television during a general election campaign.
The opening report is a story about today's announcement that the Bank of England has
raised interest rates by a quarter of a percent today to head off future inflation. The report
then moves to an interview with a politician from the governing party with a marginal
constituency in an industrial area. She says, "The Consumer Price Index has not
increased, yet the Bank of England is restricting growth in the economy, supposedly to
fight inflation. My constituents will want to know why they are going to have to pay more
for their mortgages, and why their jobs are being put at risk, and I don't have a good
answer. I think this is an outrage!"
1. What interest rate did the Bank of England actually raise?
Answer: The repo rate.
2. State the Bank of England’s policy in terms of the money supply.

Answer: They decreased the money supply (or lowered its growth rate).

3. Why might the Bank of England raise interest rates before the CPI starts to rise?
Answer: Because monetary policy acts on the economy with a lag. If the central bank
waits until inflation has arrived, the effect of its policy will arrive too late. Thus, the central
bank may wish to respond to its forecast of inflation.
4. Use the politician’s statement to explain why most economists believe that the central
banks need to be independent of politics?

Answer: Politicians must be responsive to the short-term needs of voters. Monetary policy
must take a long-term view and make politically painful decisions when the economy is
overheating (when output is above the long-run natural rate) because the proper policy
response is to contract aggregate demand.

Chapter 35
Suppose a worldwide drought has reduced food production. Inflation has increased;
unemployment has risen above the natural rate. Americans are frustrated with their
government. Your flatmate says, "This economic mess has got to be the government’s
fault. A year ago, both inflation and unemployment were lower. We need to vote in a new
government that knows how to get rid of this inflation and unemployment."
1. Whose fault is the stagflation that is present in the economy?

Answer: No one’s. It was an act of nature.

2. Are the current inflation and unemployment choices facing the economy better or worse
than before the supply shock? What has happened to the short-run Phillips curve?
Answer: Worse because the short-run Phillips curve has shifted upward.
3. If policymakers increase aggregate demand in response to the supply shock, in what
direction will the economy move along the new short-run Phillips curve? What will happen
to inflation and unemployment?

Answer: The economy moves upward along the new short-run Phillips curve.
Unemployment will be reduced but inflation will be increased.

4. If policymakers decrease aggregate demand in response to the supply shock, in what
direction will the economy move along the new short-run Phillips curve? What will happen
to inflation and unemployment?

Answer: The economy moves downward along the new short-run Phillips curve. Inflation
will be reduced but unemployment will be increased.

5. Is there a policy that can immediately